DIRECTOR OF CURRENCY RESEARCH, GFT
THE other day I saw a chart that astounded me. It was a simple chart of the Dow Jones Industrial Average over the past 20 years against a single upward sloping line. The line gently rose at about 6 per cent per year (which is the average historical compounded rate of appreciation in equities). While the line produced a smoothly rising curve the actual Dow Jones Average prices swung wildly above and below that line over the past twenty years. The message from the author of the chart was clear – to make money in the stock market you simply need to invest for the long term, ignore the daily, weekly, monthly and even yearly fluctuations and in the end you will be rich, or at least wealthier than you were when you started.
The premise looked seductively easy, so I decided to test it. I imagined an average working person who would make monthly contributions of $200 (£86 20 years ago) into the Dow Jones Industrial Average. By executing such a simple strategy I was following the two cardinal rules of long term investing. First I did not engage in any market timing. I was practicing what is known as dollar-cost-averaging. Simply put I was buying the same amount of shares every single month. When equities were expensive I bought fewer and when they were cheap I bought more. Secondly, by investing into the Dow Jones Index I eliminated all risk of individual stock picking. I wasn’t trying to beat the market – something that 85 per cent of professional money managers fail to do anyway – I was simply trying to match its returns.
I downloaded the historical data from Yahoo Finance and quickly constructed a spreadsheet. The numbers were indeed impressive. Over a 50-year time span $200 invested into the Dow Jones Industrial Average grew into a cool million bucks. (A bit more, actually.) In short, $120,000 compounded to more than 10 times its original stake and our average bloke did not have to know anything about the stock market in order to profit from the rising trend.
I was quite pleased with myself until I decided to do one final analytical test. I plotted a chart of the account equity of our “everyman” portfolio and instantly saw something that disturbed me greatly. It turns out that the account grew to more than $1m twice over its lifetime. It reached that magic mark for the first time in 2007, just before the global credit crisis, but then it went into a sickening spiral losing nearly 50 per cent of its value in little more than one year, before finally recovering to historical highs this year. One could argue that all is well that ends well, but I wondered whether most investors would be able to withstand losing nearly half of their life’s savings in one year. Furthermore, I began to question whether the buy and hold, dollar-cost-average strategy was always a wise choice in the end.
So I decided to run the numbers on another equity index. I chose the Nikkei 225, which had been in a protracted bear market, to see if the long term buy and hold strategy worked. I used the exact same rules – $200 per month every month – but this time I shortened the investment horizon to 30 years: still a very long time for most people.
The results were disastrous. After investing a total of $72,000 over a period of 30 years, the “average” Japanese account was worth a measly $47,000. The investor would have done better to stay in cash. The moral of the story is that there are no sure-fire strategies for wealth building, not even ones that advocate ultra-long holding periods. Despite the conventional wisdom that stocks over a long period of time are a sound investment, the truth of the matter is that they are highly speculative instruments that experience much greater volatility than most investors realise. Indeed, in some cases like Japan, stocks may be a losing asset for several lifetimes. So next time someone tells you that investing can be easy and simple – don’t believe them.